After more than a decade of extensive use by professional money managers, Exchange Traded Funds, or ETFs, are still not being heavily used by the general public. This is an education problem since ETFs offer a number of advantages over both managed mutual funds (called ‘active’ funds) and index mutual funds (called ‘passive’ funds). With actively managed mutual funds, the fund company hires a manager who actively buys and sells stocks and bonds in an attempt to outperform a certain benchmark such as the S&P 500 Index. With passively managed mutual funds, the fund company hires a computer programmer who ‘matches’ the exact same securities held in a particular index such as the S&P 500 Index. Let’s look at some of the comparative benefits of owning ETFs:
- Like index mutual funds, an ETF represents a specific index such as the S&P 500 (U.S. large companies) or the Wilshire 5000 (the entire U.S. stock market) or the Russell 2000 (U.S. small companies). For example, by buying the ETF version (symbol SPY) of the S&P 500 Index, with one security purchase you own shares in 500 companies.
- Like index mutual funds, ETF expenses are very low. Where Vanguard Total Stock Market Index (VTSMX) mutual fund charges 0.18% annually, their own ETF version (VTI) charges a meager 0.09% annually. Compare this to the management fee of the typical actively managed mutual fund, which averages 1.4% annually.
- ETFs are highly tax efficient. By law, mutual funds are required to distribute at least 95% of all net realized capital gains each year to their investors as of a certain date, called the ‘record date’. While this has been less of a problem with index mutual funds, it has been a significant problem with many managed mutual funds. ETFs minimize this problem as you only recognize gains when you sell an ETF in which you have made money. With a mutual fund, it is possible to actually have losses for the year, yet get hit with taxable gains on fund distributions.
- ETFs trade like stocks…on an intra-day basis whereas mutual funds settle at the close of the day’s prices. Under the new paradigm we find ourselves today where dramatic market changes can happen in the course of a single day, this can be an important benefit.
- Many mutual funds, even no-load funds, charge a redemption fee when you sell your fund within a certain period of time from purchase (typically 90-days). ETFs do not have such restrictions, allowing investors to remain mobile and responsive to rapidly changing events. While I believe in having a long-term investment strategy, it’s important to maintain the flexibility to make changes should extraordinary circumstances arise.
- You now have access to over 700 different types of ETFs, allowing you to be very strategic in your investing while still maintaining significant security diversification. We use ETFs extensively in managing our client’s portfolios and have found them to be an excellent cost efficient management tool.